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THE BOOM IN EXCHANGE-TRADED FUNDS IS reshaping the investment landscape by challenging traditional mutual funds and giving investors, large and small, the opportunity to get exposure to virtually every major market and asset class in the world—and many minor ones as well.

ETFs are passive mutual funds and trusts that trade like stocks on major exchanges; they can be bought or sold anytime during the trading day. They held a record $940 billion of assets in the U.S. on Oct. 31, up from $794 billion at year-end 2009, and are on track to hit $1 trillion around the end of 2010.

Net inflows totaled $89 billion in the first 10 months of the year, as investors poured money into ETFs focused on developing-market stocks, bonds and precious metals. Exchange-traded funds are gaining market share at the expense of traditional mutual funds, which (excluding money-market funds) hold about $8 trillion of assets.

The benefits of exchange-traded funds include low fees, relative to mutual funds, transparency of investments and tax efficiency because of low portfolio turnover. These funds provide exposure to specific indexes, like the Standard & Poor's 500 or Russell 2000, as well as such investments as gold, natural gas, junk bonds, inflation-protected Treasuries and master limited partnerships. "A lot of investors are realizing the benefits of diversification, and ETFs allow broad diversification at low cost," says Gus Sauter, chief investment officer at Vanguard. It's understandable that investors favor broader portfolios because a U.S-focused equity strategy hasn't done well in the past 10 years, in which the S&P 500 has essentially been flat. As global economic power shifts away from developed markets, investors want exposure to rising countries like China, India and Brazil.

The ETF business is highly concentrated, with the 10 largest funds—out of a universe of about 1,000—accounting for 40% of all assets and three just issuers,
BlackRock's
BLK -0.7173431734317344%BlackRock Inc.U.S.: NYSEUSD336.32
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20619
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16.96871846619576Market Cap
55956585759.6118
Dividend Yield
2.5927687916270217% Rev. per Employee
931311More quote details and news »BLKinYour ValueYour ChangeShort position
(BLK) iShares, State Street Global Advisors and Vanguard, controlling 82% of industry assets. Trading in ETFs averages $62 billion a day and accounts for about 25% of the volume on U.S. exchanges.

ETFS ARE A GREAT democratizing force. With a click of a mouse, individuals can get access to stocks in virtually every corner of the world and to assets like commodities that can be cumbersome to buy and largely have been limited to institutions.

A Booming Sector

More than 1,000 exchange-traded funds exist, covering everything from emerging-market stocks to energy to U.S. blue chips and Treasury bonds. Through October, ETFs pulled in a net $89 billion in assets this year.

Each GLD share, now at $134, equals 1/10th of an ounce of gold, minus a management fee of 0.40% a year. That modest fee has been well worth paying, given the doubling in gold's price since 2008.

Critics say that an influx of ETF money may be contributing to a bubble in some commodities like silver, which has jumped 20%, to $26 an ounce, since Sept. 30.

Investors have been focusing on commodities and other hard assets to play growing demand in the developing world and amid fear that the Federal Reserve's controversial plan to print money via the purchase of $600 billion of U.S. Treasury securities over the coming months will debase the dollar and spur inflation. Cotton has doubled in price since midsummer and a new cotton exchange-traded note,
the iPath Dow Jones-UBS CottonBAL 0.7060265673436192%iPath Bloomberg Cotton Subindex Total Return ETNU.S.: NYSE Arca42.72
0.29950.7060265673436192%
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N/AMore quote details and news »BALinYour ValueYour ChangeShort position
(BAL) is up by a similar amount.

Many real users of commodities contend that investment demand has distorted markets. Gold jewelry demand, for instance, has fallen as the metal's price has shot up. There is a rush to roll out the first physical U.S. copper ETF (see ETF Focus), whose launch could further propel prices of that key industrial metal, already up 20% this year, to $4 a pound. That said, the presence of an ETF on natural gas,
U.S. Natural GasUNG -2.175543885971493%United States Natural Gas Fund L.P.U.S.: NYSE Arca13.04
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N/AMore quote details and news »UNGinYour ValueYour ChangeShort position
(UNG), hasn't helped gas prices, which are down 35% this year to $3.70 per million BTUs.

Discount and full-service brokers want to capitalize on the ETF boom. Financial advisors who once picked stocks for clients and later selected mutual funds have morphed into asset allocators, and ETFs are an easy and low-cost way to get diversification. The annual expenses on the average one are around 0.50%—one-half to one-third the fees of many mutual funds—and many ETFs charge 0.10% or less.

Schwab has made a major push into ETFs; its clients now hold $100 billion worth of them. The brokerage firm offers managed ETF portfolios, tailored to individual investment goals and risk tolerance, for investors willing to put up a minimum of $100,000. The fee is 0.75% annually for accounts up to $500,000, and lower for levels above that. Overall, the average total yearly fee—including the portion that pays for ETF expenses—is reasonable, at close to 1%.

One obstacle to growth is unfamiliarity. "If you asked eight out of 10 people, they probably wouldn't know what ETF stands for," says Peter Crawford, a senior vice president at Schwab's client group. Just 17% of Schwab's retail clients now own exchange-traded funds.

AMONG THE KEY differences between mutual funds and ETFS are that mutual funds can only be traded once a day, while exchange-traded funds can be bought or sold whenever exchanges are open. Most mutual funds are actively managed, while virtually all ETFs are passive. Actively managed ETFs probably will remain scarce because government regulators appear loath to approve them. Active managers are reluctant to disclose their holdings daily, partly for competitive reasons. ETFs, in contrast, provide such disclosure.

How do exchange-traded funds add assets? When investors buy shares, the ultimate sellers are designated market makers. When these market makers see their inventories depleted, they create new shares by purchasing the underlying investments and then delivering them to the ETF manager for new shares. Likewise, heavy selling of exchange-traded funds prompts market makers to liquidate the underlying investments, extinguishing shares.

Vanguard has made the biggest inroads in ETFs, gathering an industry-leading $32 billion in net assets this year, due in part to fees that average just 0.18% annually—a third of the industry average.

THE ISHARES BUSINESS is a great one. It generates operating-profit margins around 40% for BlackRock, which bought it from Barclays for $14 billion last year, when the British bank was reeling from the financial crisis. BlackRock doesn't need highly paid active managers to run the ETFs, and any incremental assets they attract have extremely high margins. The purchase was a shrewd diversification move by BlackRock boss Laurence Fink. A once-obscure bond manager, BlackRock now manages $3.4 trillion in assets and has a $30 billion stock-market value, tops among publicly traded U.S. asset managers.

The most controversial ETFs are those designed to move two and three times the daily change in their underlying indexes by using leverage or financial derivatives. There are 290 leveraged and inverse ETFs, with $40 billion in assets, BlackRock says.

Other Notable ETFs

These all offer an easy way to play specific investments, markets or sectors.

Recent

YTD

Assets

Fund/Ticker

Price

Total Return

(bil)

Comment

iShares Silver Trust/SLV

$27.11

62%

$9.6

Biggest silver ETF, up 12% in past month

SPDR S&P Dividend/ SDY

51.75

15

4.4

Buys S&P dividend "aristocrats"

SPDR Barclays Capital High Yield Bond/JNK

40.44

13

6.3

Invests in U.S. junk bonds

iShares S&P National AMT-Free Muni/MUB

102.58

4

2.2

Buys U.S. municipal bonds

iPath S&P 500 VIX Short-Term Futures/VXX

45.43

-67

1.7

Offers play on depressed VIX index

Alerian MLP/AMLP

16.02

NA

0.4

Buys master limited partnerships

US Natural Gas Fund/UNG

5.67

-42

2.5

Play on battered gas market

ProShares UltraShort 20+Year Treasury/TBT

36.44

-27

5.4

Anti-Bernanke play on higher rates

Vanguard European/VGK

51.27

7

2.9

Buys European stocks, yields 4%

PowerShares DB Commodity/DBC

26.36

8

4.7

Offers broad commodity exposure

All data as of Nov. 11. NA=Not applicable.

Source: Bloomberg

These funds have been criticized because over long periods, they often don't track the underlying indexes. That isn't because of an inherent flaw, but because of the effects of compounding often large daily movements.

As a result, the Financial Industry Regulatory Authority (Finra) said last year that "inverse and leveraged ETFs that reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets." Investors seem to be heeding this advice, because the Direxion 3x financial stock funds have a combined $3 billion in assets, despite enormous daily trading volume averaging 45 million shares for the bullish fund (FAS) and 54 million for the bearish one (FAZ).

To take a simple example, if financial stocks rise 10% one day and fall 10% the next day, the index will drop 1%, to 99, from the original 100 level. A three times leveraged bullish fund would rise to 130 on the first day and then fall to 91 on the second, a 9% drop. The bearish fund would slip to 70 on the first day before rallying to 91 on the second, also producing a 9% decline.

Both the FAS and FAZ have been tough on investors this year and show the pitfalls of an extended investment in leveraged ETFs. The FAS is down just 4%, while the FAZ has plunged 40% and is down 99% since early 2009. All the inverse double-leveraged sector ETFs on the S&P 500 are off sharply this year.

In a cover story at the start of 2009, Barron's argued long-term Treasury yields, then around 2.70%, probably would go higher. That's been the case, with the 30-year T-bond, now yielding 4.25%. The
ProShares UltraShort 20-Year TreasuryTBT -1.5669205658324266%ProShares UltraShort Lehman 20+ Year TreasuryU.S.: NYSE Arca45.23
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(TBT), however, is down about 10% since then, to 35. It offers the inverse of twice the daily change in the price of long-term Treasuries.

Despite its drawbacks, the TBT is one of the few ways for individuals to bet on higher long-term Treasury rates. The rates already have risen 0.25 percentage point this month and could approach 5% if the Fed's controversial second quantitative easing program boosts inflation and a rout ensues in the bond market. It isn't easy for individuals to short Treasuries. Another alternative is to short the
iShares Barclays Capital 20+ Year Treasury BondTLT 0.7399490257337827%iShares 20+ Year Treasury Bond ETFU.S.: NYSE Arca122.53
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2.5283636660409696% Rev. per Employee
N/AMore quote details and news »TLTinYour ValueYour ChangeShort position
ETF (TLT).

Master limited partnerships focused on transporting energy have done very well in the past two years because of investors' hunger for dividends. The Alerian MLP index is up 27% this year, after gaining 62% in 2009. One of the problems with MLPs is that investors get K-1 dividend tax forms—which are more complicated to deal with at tax time than 1099s. The
Alerian MLP AMLP -0.5164622336991608%Alerian MLP ETFU.S.: NYSE ArcaUSD15.41
-0.08-0.5164622336991608%
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Volume (Delayed 15m)
:
3564243
P/E Ratio
N/AMarket Cap
3113830000
Dividend Yield
7.670343932511356% Rev. per Employee
N/AMore quote details and news »AMLPinYour ValueYour ChangeShort position
ETF (AMLP), however, offers 1099s to holders, along with the diversification of 25 MLPs.

COMMODITY ETFS like the UNG that use futures can be hurt by contango, a term that simply means that future prices are higher than current or spot prices. Contango forces an ETF to roll its spot contracts into higher-priced futures. The UNG has badly trailed gas prices since its creation. That said, it offers a play on the depressed gas market. Prices are down 35% this year, to $3.70 per million BTUs, and are trading at a historically low valuation, relative to oil, now at $86 a barrel. Some investors prefer ETFs that hold physical assets, although that can be tough for some commodities, owing to storage constraints.

Investors can get ETF information from many Websites, including cefconnect.com, xtf.com, etfdb.com and etftrends.com, as well as Morningstar, Yahoo! and Marketwatch.com.

Regardless of how they do it, investors should learn more about ETFs, because they're here to stay—and are growing more important every day.